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IRS issues long-awaited initial guidance on US taxation of cross-licensing of patents

On February 14, 2007, the IRS issued Revenue Procedure 2007-23, which contains long-awaited initial guidance on the cross-licensing of patents. In 2006 the IRS sent chills through some in the patent community when it requested comments, information and documents on cross-licensing arrangements. Traditionally, few, if any, taxpayers who entered into cross-licensing arrangements had taken such arrangements into account for US tax purposes. The bulk of the comments received by the IRS urged the IRS to tax "income" attributable to cross-licensing arrangements ONLY if there was an actual cash distribution to one or both of the parties under the arrangement.

In issuing the Revenue Procedure, the IRS considered the comments received and determined that, "in the interest of sound tax administration, taxpayers are not required to take into account amounts other than the 'net consideration'" in connection with "Qualified Patent Cross-Licensing Arrangements" ("QPCLA"). This is good news for most taxpayers because it comports with their current treatment of such arrangements.

According to the Revenue Procedure, if a cross-licensing arrangement is a QPCLA and there is no exchange of consideration between the parties (other than entering into the cross-license and the transfer of other de minimis intellectual property) and the parties to the cross-licensing arrangement are not related to one another, then the "value" to each party to the cross-licensing arrangement will not be taken into account for US federal income tax purposes. As a result, there will not be a 30% US withholding tax imposed in connection with such QPCLA unless there is actual net consideration transferred to the foreign cross-licensor. In addition, only the amount of the net consideration under such an arrangement will be subject to capitalization under Internal Revenue Code sections 263(a) or 263A.

Defining a QPCLA

To qualify for this treatment and use the net consideration method, the cross-license arrangement must be a QPCLA. According to the Revenue Procedure, a QPCLA is a nonexclusive, nontransferable patent cross-licensing arrangement among unrelated parties, the subject matter of which is limited to the parties' present or future patent rights, as specified in the arrangement. However, the Revenue Procedure cautions that if the parties to an arrangement also engage in more than de minimis licensing or other transfer of other intangible property (including copyrights, trademarks and know-how) pursuant to the arrangement, the arrangement is not a QPCLA. The determination of whether the licensing or other transfer of other intangible property is de minimis is determined under all the facts and circumstances.

According to the Revenue Procedure, a change in the reporting of a QPCLA to the Net Consideration Method is a change of accounting method and will require IRS consent.

Effective Date

In general, the Revenue Procedure is effective for QPCLA entered into on or after February 14, 2007. However, taxpayers with existing agreements should take some solace because according to the Revenue Procedure, use of the Net Consideration Method for QPCLA entered into before that date will not be raised as an issue by the IRS on audit and, if it already has been raised, will not be pursued further.

There is no indication in the Revenue Procedure how non-QPCLA will be treated. However, the IRS has requested comments on this issue and other open issues related to cross-licensing arrangements.